New Tax Law Means New Opportunities

Most "Preferred Dividends" Are Actually Interest The Pursuit of Dividends After The Tax Act of 2003: Limitations, Traps and Ambiguities

The Jobs and Growth Tax Relief Reconciliation Act of 2003 dramatically alters the balance between competing types of investments. The lower 15% tax rate for dividends should prompt investors to reassess both their securities and the “pockets” in which they hold their securities. Growth stocks still belong in taxable accounts and interest-bearing investments in tax-deferred accounts, but high-yielding equities now migrate from the tax-favored “pocket” to the taxable.

The lower dividend tax should prompt investors to examine possibilities for earning dividends in a more conservative manner than outright ownership of common stocks.  Fortunately, there is a 20 year history of dividend capture strategies, which until now were used by corporations aiming to get the dividends received deduction, or DRD, without taking on too much risk.  The tax law applies the DRD rules to individuals capturing the 15% tax on dividends, so individuals may now wish to replicate these strategies.  The rules regarding DRD eligibility seem simple, although there are tricky exceptions.  In essence, the rules generally require that corporations hold their dividend-paying shares for at least 46 days unhedged.  For an individual seeking to capture the 15% dividend tax, the unhedged holding period would be 61 days.  This requirement applies to every dividend period.   If investors hedge stocks during this period, they generally will not be eligible for the reduced 15% dividend tax for dividends on the hedged securities.

Update: Under the American Jobs Creation Act of 2004, writing in-the-money calls suspends the holding period required to capture dividends or the DRD. See Tougher Rules For Hedging Dividends.

During the 61-day holding period, the only conventional derivative strategy that an investor may use to protect the dividend-paying stock would be to sell a qualified covered call option, or QCC.  The rules defining QCCs were not changed by the new law.  These rules are complex, but a call generally constitutes a QCC if it meets three basic conditions.  First, when the investor enters into the call, the call must have more than 30 days remaining to expiration but not more than 33 months.  Second, options on the underlying stock must be listed on an options exchange.  Third, the call must not be too deep in-the-money, defined as having a strike price below a certain minimum.  This minimum strike price is usually one strike below the stock’s previous day closing price, but, in addition, the strike price must be at least 85% of the previous close, and a more rigorous formula applies to calls with terms over twelve months.  

The law generally allows investors to hedge their portfolios with index options unless the portfolio and the index “mimic” each other.  A mimic of an index is defined as ownership of 70% or more of the index.

Twenty-First also believes the new law should heighten investor interest in a Lehman invention, the auction rate preferred.  This preferred’s interest rate is reset every 49 days by auction. Because this system regularly adjusts the interest rate to market conditions such as prevailing rate movements, changes in credit quality, or even changes in tax rates, the auction rate preferred is designed to always trade at par.

The new tax law allows a favorable arbitrage in which an investor establishes both long and short positions in different equities.  The dividend income from the long positions should be taxed at only 15%, while short dividend payments should be deductible against 35% income.

The new law should also change the dynamics of stock loans.  During the loan period, the borrower is generally required to remit payments in lieu of any dividends distributed.  These substitute payments convert dividend income into ordinary “other” income for the lender of shares.  Beginning in 2004, brokers will be required to report “in lieu of” dividend payments as such, and these payments will be taxed as ordinary income at the 35% rate.  This extra tax would not apply to foreigners or to tax-exempt investors, and the burden might be insignificant for hedged investors and short-term traders.  However, for many individual investors, the tax consequences may be substantial, and so these investors may become less willing to lend.

While the law changes the bottom line for many investment strategies, it does not alter the way regulated futures are taxed.  Although a change was contemplated, under U.S. Internal Revenue Code Section 1256, gains and losses on these contracts are treated as 60% long-term and 40% short-term.  Under the new law’s tax rates, the net tax is lowered from 27.44% to 23%.

The tax law is clearly an historic piece of legislation, and its ramifications are yet to be discovered.  However, one thing is clear: since dividends are now taxed as favorably as long-term gains, substantial taxable investors should be thinking more of equities.

 

This article and other articles are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein Options involve risk and are not suitable for all investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".